What Is Income?

Income is money (or some equivalent value) that an individual or business receives, usually in exchange for providing a good or service or through investing capital. Income is used to fund day-to-day expenditures. Investments,聽pensions, and聽Social Security are primary sources of income for retirees. For individuals, income is most often received in the form of wages or salary. Business income can refer to a company's remaining revenues after paying all expenses and taxes. In this case, income is referred to as "earnings.鈥 Most forms of income are subject to taxation.

Key Takeaways

  • Income is money what an individual or business receives in exchange for providing labor, producing a good or service, or through investing capital.
  • Individuals most often earn income through wages or salary. Businesses earn income from selling goods or services above their cost of production.
  • Tax authorities treat income earned through various means differently.
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Income

Understanding Income

Individuals receive income through earning wages by working and making investments into聽financial assets such as stocks,聽bonds, and real estate. For instance, an investor鈥檚 stock holding may pay income in the form of an annual 5% dividend.

In most countries,聽earned income聽is taxed by the government before it is received. The revenue generated by聽income taxes聽finances government actions and programs as determined by federal and state budgets. The Internal Revenue Service (IRS) calls income from sources other than a job, such as聽investment income, 鈥渦nearned income.鈥

Taxable Income

Income from wages, salaries, interest, dividends,聽business income, capital gains, and pensions received during a given tax year are considered taxable income in the United States. Other taxable income includes annuity聽payments, rental income, farming, and fishing income,聽unemployment compensation, retirement plan distributions, and聽stock options. Lesser-known taxable income includes gambling income, bartering income, and jury duty pay.

The types of income listed above would be classified as ordinary income, which is composed mainly of wages, salaries, commissions, and interest income from bonds, and it is taxable using ordinary income rates. This type of income differs from capital gains or dividend income in that it can only be offset with standard聽tax deductions, while聽capital gains聽can only be offset with聽capital losses.

Tax-Exempt and Tax-Reduced Income

Types of income that may be tax-exempt include interest income from聽U.S. Treasury聽securities (which is exempt at the state and local levels)锘 , interest from聽municipal bonds聽(which is potentially exempt at the federal, state and local levels)锘 and聽capital gains聽that are offset by聽capital losses.

Types of income taxed at lower rates include qualified dividends聽and long-term capital gains. 锘 Social Security income is sometimes taxable, depending on how much other income the taxpayer receives during the year.

Disposable and Discretionary Income

Disposable income is money that鈥檚 remaining after paying taxes. Individuals spend disposable income聽on necessities, such as housing,聽food, and transportation. Discretionary income is the money that remains after paying all necessary expenses.聽People聽spend discretionary income on items like vacations, restaurant meals, cable television, and movies.

In a recession,聽individuals聽tend to be more prudent with their discretionary income. For example, a family may use their discretionary income to make extra payments on their mortgage or save it for an unexpected expense.

Disposable income is typically higher than discretionary income within the same household because expenses of necessary items are not removed from the disposable income. Both measures can be used to project the amount of consumer spending. However, either measure must also take into account the willingness of people to make purchases.

Examples of Income

For private individuals, ordinary income is usually only made up of the salaries and wages they earn from their employers pretax. If, for example, a person works a customer service job at Target and earns $3,000 per month, his annual ordinary income would be $36,000, derived as $3,000 x 12. If he has no other income sources, this is the amount that would be taxed on his year-end tax return as gross income.

Additionally, if the same person also owned a rental property and earned $1,000 a month in rental income, his ordinary income would increase to $48,000 per year. If the same person earned $1,500 in qualified municipal bond interest payments, that portion of income would be tax-exempt.

For businesses, ordinary income is the pretax profit earned from selling its product or service. For example, the retailer, Target, had $69.5 million worth of total sales or revenue in the year ended in January 2017. The company had $48.9 million in costs of goods sold (COGS) and $15.6 million in total operating expenses. Target鈥檚 ordinary income was $5 million锘 , derived as follows:

  • $69,500,000 - $48,900,000 - $15,600,000

This is the amount of income that would be taxed for the year. However, businesses are required to pay taxes quarterly.